New Standard on Accounting for. Pension and Other Postretirement. Could Affect Existing Business Obligations. By Randall D.

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1 New Standard on Accounting for Pension and Other Postretirement Could Affect Existing Business Obligations By Randall D. McClanahan The unexpected accrual of liabilities can cause significant problems in financial statement ratios. A recent accounting pronouncement, FAS No. 158, Employers Accounting for Defined Benefit Plans and other Postretirement Plans ( FAS 158 ), issued by the Financial Accounting Standards Board (the FASB ) on September 29, 2006, could have this result. In adopting FAS 158, the FASB maintained most of the material provisions of its March 31, 2006 Exposure Draft. As a result, businesses that provide defined benefit plans and other postretirement plans for their employees may have to accrue additional pension liabilities. FAS 158 represents the first phase of the FASB's comprehensive project on accounting for pension plans. The FASB will address other pension issues in a broader phase in the future. FAS 158 requires an employer to recognize in its balance sheet the amount of the overfunded or underfunded status of the defined benefit retirement plan (other than a multi-employer plan). The amount to be recognized is equal to the difference between the fair value of the plan assets and the projected benefit obligation. pension.doc.2 1

2 Additionally, the FASB proposes to require an employer to recognize the amount of the overfunded or underfunded status of other postretirement plans. The amount to be recognized would be equal to the difference between the fair value of the plan assets and the accumulated postretirement benefit obligation (based on the current as opposed to the projected obligation). While such postretirement plans are likely to be smaller in value than defined benefit plans, such plans may be more likely to be significantly underfunded. Additionally, the gains or losses of prior service costs or credits arising during the applicable period must be recognized in other comprehensive income, net of any tax effect, and then amortized. Why are these potentially significant changes? Under prior generally accepted accounting principles, the overfunded or underfunded status of postretirement plans was disclosed in the footnotes, but not accrued on the balance sheet. While the calculation of the status of postretirement plans does not change under FAS 158, the recognition of the status in the balance sheet will likely increase liabilities and decrease stockholders equity. The fair value of plan assets is the fair market value of the pension plan assets as of a particular point in time, which, after fiscal years ending after December 15, 2008, will have to be the end of the company s fiscal year. The projected benefit obligation is the actuarially determined value of all pension benefits, including estimated expected future compensation levels. If compensation increases, projected retirement benefits usually also increase. As a result, an employer takes into account expected increases in both salaries and associated benefits in computing its potential liability. More likely than not, the application of FAS 158 will result in a reduction in total equity of an entity pension.doc.2 2

3 subject to its provisions. For example, a recent July 2006 Towers Perrin study, "Assessing the Impact of the Planned Changes in Accounting for Pensions and Other Postretirement Benefits," reported that if FAS 158 were effective at December 31, 2005, equity in the Fortune 100 companies that sponser defined benefit plans would have been reduced by an estimated 8.3%. The effective date for all public entities is the first fiscal year ending after December 15, 2006 (i.e., 2006 for calendar year entities and fiscal year June 30, 2007 for fiscal year June 30 entities). For non-public entities, the effective date is the first fiscal year ending after June 15, Consequently, there is a reasonably likelihood that public company employers with defined benefit plans will have to accrue a liability in 2006, and non-public entities will have to accrue a liability in A defined benefit plan is a plan that contains a stated pension benefit formula. The formula basically describes the amount of benefit an employee will receive for providing services during a specified period. The term other postretirement plans constitutes all other plans provided by employers other than retirement plans. The most common form of such a plan is a post-employment medical plan. FAS 158 does not apply to defined contribution plans. Instead of a formula, a defined contribution plan usually states (i) the amount an employer must contribute to the plan, and (ii) the method for allocating the employer s contributions to employees that pension.doc.2 3

4 provided services during that period. Since contributions under defined contribution plans are made periodically, the unfunded liability concerns are not as applicable. Now, a real potential problem what effect will FAS 158 have on existing contracts? The most common agreements that may be affected are probably loan documents, including indentures, which often contain financial covenants by the borrower. The failure of a borrower to maintain certain specified financial ratios usually constitutes an event of default under a loan agreement. Loan documents typically include covenants requiring the borrower to continuously satisfy certain minimum financial ratios, such as the debt/equity ratio and the current ratio (equal to current assets/current liabilities). FAS 158 could affect all ratios that include liabilities and equity in their computation unless the loan document provides that the financial ratios shall be calculated in accordance with generally accepted accounting principles in effect on the date of the loan agreement. Most liabilities resulting from the underfunded status of defined benefit plans are likely to be accounted for as long-term liabilities because the fair value of plan assets are likely to be sufficient to cover the expected payments over the next twelve months. Therefore, ratios that include long-term liabilities in their computation (such as the debt/equity ratio) likely will be the most significantly influenced. Entities that are currently not in default under loan documents with financial institutions or holders of other debt securities could face default once they comply with FAS 158 if the inclusion of an accrued pension liability causes such entity to fail a pension.doc.2 4

5 financial covenant. Therefore, the renegotiation of those loan agreements now, before year end financial statements are finalized, is important. Any such negotiations should also take into account any impact of compliance with FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, ( FIN 48 ), since FIN 48 is effective also for financial statements for fiscal years ending after December 15, 2006). Unfortunately, the analysis does not stop with loan agreements. There are various other contractual agreements that should be analyzed, perhaps most commonly contracts relating to the purchase or sale of equity interests based upon pre-determined valuation formulas. Such arrangements typically relate to private companies and, as a result, FAS 158 would not apply to most of these arrangements until For example, many closely held businesses grant equity interests to key employees. Typically, the parties enter into an agreement that restricts the ability of the employee to transfer the equity interest, and also provides for the purchase of the equity interest upon the employee s termination of employment, death, or disability. The purchase price is usually based upon either (i) an appraisal or (ii) a pre-determined formula that relies on the balance sheet of the entity, such as book value (i.e., assets less liabilities). The accrual of an unexpected liability would immediately increase the total liabilities and correspondingly reduce the book value of the interest. As a result, the amount that an employee would receive on the sale of his or her equity interest would decline unexpectedly. In summary, as a result of FAS 158, entities should review their loan agreements to determine whether they need to renegotiate any debt covenants to avoid a default upon pension.doc.2 5

6 compliance with FAS 158. Additionally, any other agreements that could be materially affected by changes in financial ratios should be reviewed. For example, employees and employers should review any agreements regarding the purchase or sale of equity interests. If the purchase price would be materially modified by a material increase in the amount of the liabilities of the employer, these parties may wish to modify their agreements to reflect a more appropriate purchase price. Randall D. McClanahan is a partner with Johnston Barton Proctor & Powell LLP and is chairman of the Accounting Standards Subcommittee of the ABA Business Law Section s Law and Accounting Committee. Randall D. McClanahan Johnston Barton Proctor & Powell LLP 2900 AmSouth/Harbert Plaza 1901 Sixth Avenue North Birmingham, Alabama Phone rdm@jbpp.com pension.doc.2 6